ECB Loans Plant Seeds of European Disintegration

The ECB began two rounds of extraordinary three-year loans at an interest rate of 1 percent in December in its longer-term refinancing operations. Photographer: Hannelore Foerster/Bloomberg

May 1 (Bloomberg) -- European Central Bank measures to stem
the region’s debt crisis threaten instead to undermine the euro.

ECB loans worth more than $1.3 trillion have been recycled
into government bonds, capping borrowing costs. As Italy’s
reliance on its local institutions increases and Spanish banks
accelerate purchases of domestic government securities, however,
the economic ties that bind the fate of euro members to each
other loosen, weakening the incentives for cross-border support
to defend the currency union.

“As the local bond markets have become owned only by
domestic institutions, there is less and less incentive for the
other countries to support and bail out one of those,” said
Stephane Monier, who helps manage more than $150 billion as head
of fixed income and currencies at Lombard Odier Investment
Managers. “Basically you’re planting the seeds for the
disintegration of the euro zone.”

The ECB began two rounds of extraordinary three-year loans
at an interest rate of 1 percent in December in its longer-term
refinancing operations. Italian banks boosted their government
debt holdings to 323.9 billion euros ($428.1 billion), from
301.6 billion euros in February and 247.4 billion euros in
November, according to the ECB. Spanish banks own 263.3 billion
euros of government securities, up from 245.6 billion euros in
February and 177.9 billion euros in November.

Off Target

Since the LTROs, both nations have said they will miss
deficit-reduction targets agreed with the European Commission,
driving Spain’s two-year yield to 3.36 percent, more than one
percentage point above this year’s low. Italian yields have
jumped almost 1.5 points since their 2012 low, reaching 3.14
percent, while German yields fell to a record-low 0.075 percent
on April 27.

Meanwhile, foreign investors are selling, separate data
shows. Non-residents cut their holdings of interest-bearing
Spanish government bonds by 20 billion euros, or 9.3 percent, in
March, according to a document published on the website of
Spain’s economy ministry on April 27.

“Everywhere when you have a crisis, you have a re-domestication of markets,” said Laurent Fransolet, head of
fixed-income strategy at Barclays Capital in London. “In Spain
and the other peripheral countries, it is clear there has been
very large selling by foreign investors and someone needs to
pick that up. The uncertainty is making investors more
jittery.”

Deeper Recessions

Spain’s cost to borrow for 10 years rose 42 basis points
last month, and reached 6.16 percent on April 16, the most since
Dec. 1. Italy’s 10-year rate has risen to 5.39 percent from 5.12
percent at the start of April. The euro weakened to a more than
16-month low of $1.2624 in January. It fell 0.1 percent today to
$1.3209 at 4:17 p.m. London time. Euro-region government bond
markets are closed for a holiday.

Deepening recessions in the two nations contributed to the
slide in the securities as shrinking tax revenue makes it harder
to cut deficits. Spain’s economy contracted 0.3 percent in the
first quarter, putting the euro region’s fourth-largest economy
into its second recession since 2009, data showed yesterday.
Italy’s consumer confidence plunged this month to the lowest
since 1996 as Prime Minister Mario Monti’s austerity measures
crimp growth.

Bonds from the two nations handed investors the biggest
losses in the euro region last month, according to data compiled
by Bloomberg and the European Federation of Financial Analysts
Societies. Spanish government bonds lost 1.8 percent in April,
while Italian securities declined 1.3 percent, the indexes show.

Rating Cuts

Spain’s rating was cut on April 26 for the second time this
year by Standard & Poor’s, which cited concern the country will
have to provide further support to its banks as the economy
contracts. S&P yesterday lowered its grades for 11 Spanish
banks, including Banco Santander SA and Banco Bilbao Vizcaya
Argentaria SA, citing “potentially negative implications” from
the sovereign cut.

“The ECB’s liquidity measures are a double-edged sword,”
said Gianluca Ziglio, an interest-rate strategist at UBS in
London. “On one hand they boosted demand for the sovereign
paper, but on the other they increased the exposure of the banks
to the volatility and widening spreads.”

‘Marked Deterioration’

The sovereign-debt crisis has caused a “marked
deterioration” in financial integration in the euro area, the
ECB said in a report published on April 26. “During 2011, the
intensification of the sovereign-bond crisis strongly affected
the euro-area financial system” it said. The ECB’s next policy
meeting is on May 3.

Luxembourg Prime Minister Jean-Claude Juncker yesterday
said he’s stepping down as head of the group of euro-area
finance ministers because he’s tired of Franco-German
interference in managing the region’s debt crisis. “They act as
if they are the only members of the group,” he said at a podium
discussion in Hamburg.

“The magic of the LTROs has worn off quickly because non-residents have sold off their holdings,” said Richard McGuire,
a senior fixed-income strategist at Rabobank International in
London. “The LTROs seem to be accelerating de-euroization, the
euro-region financial system seems to be compartmentalizing and
investors are tending to stick to their home market. That makes
them much more vulnerable.”